Tougher economic conditions, but the IFS suggests the Chancellor’s rules are holding back growth

Yesterday the IFS set out a bleaker view for the economy and public finances in its Green Budget, which is published every year in the run-up to the Chancellor’s Budget Statement. Given the gloomy projections, let’s hope the government takes note, especially with regard to the fiscal mandate.

Macroeconomic prospects: average

Oxford Economics’ Andrew Goodwin outlined how growth has come in lower than expected, with 2015 GDP growth decidedly disappointing at 2.2 per cent.

There are some positive stories: business investment is presently growing faster than GDP and consumer spending has been boosted, supported in part by low oil prices. However, there is some question over the sustainability of these boons. As the referendum nears, the uncertainty about ‘Brexit’ is likely to slow business investment. Furthermore, whilst consumer spending may continue to experience a “sugar rush” as oil prices look set to fall even further, the harsh welfare cuts is going to mean a very real £12.5 billion loss to household incomes.

Substantial drags on growth have also been identified, in particular the weakness in the UK’s current account position – a result of the relatively strong pound and the weak economic recovery witnessed in some of our main trading partners, especially in the Eurozone.

Furthermore other risks to growth come from the present turmoil in global financial markets and the potential hikes in the interest rate by the US Federal Reserve.

Fiscal mandate: counter-productive

A significant drag on growth also comes in the form of George Osborne’s “fiscal mandate”. This is the rule, widely understood as a political device, requiring him to achieve a headline surplus every year from 2019-20 (unless GDP growth drops below 1 per cent). The IFS yesterday stressed how difficult this is going to be for Osborne to achieve. The explanation they gave is that tax revenues are incredibly difficult to forecast, for example if we consider Income Tax and National Insurance Contributions they are both extremely dependent on earnings and employment rates, and we know forecasts of growth in earnings has been consistently over-optimistic in recent years.

However, the fundamental question, as it appears to me, is why would we ever want a surplus? Does it stem from a libertarian ideological instinct that the size of the state needs to be severely shrunk? Or is it a result of legitimate concerns: the potential for fiscal expansion to counter the next crisis we face, the risk debt overhang poses to future growth, the burden being left behind for young people to bear? If it is the latter and not the former then what matters is not the short-run matter of the surplus being run each year but the long-term concern about the debt-to-GDP ratio. And the debt-to-GDP ratio can be reduced in two ways: GDP growth or a reduction in borrowing.

And here we reach the crux of the matter. The supply side of our economy is not perfect but is looking a heck of a lot stronger than the demand side. There has been strong growth in labour supply (a result of migration and the increase in the State Pension age) and capital (a consequence of growing business investment). The conclusion the IFS reached, something which we have also repeatedly argued, is that there is substantial spare capacity in the UK economy. This means that the constraint on demand is causing a significant “output gap”, where actual GDP is far below equilibrium output (the output at which the target level of inflation can be achieved). The rigid austerity pursued by the government appears to explain this demand deficit; thus it seems that the Chancellor is forcing through his fiscal mandate at the cost of GDP growth. And this argument is cyclical: lower GDP growth will correlate with weaker tax revenues, and so the plausibility of achieving the surplus is called even more into doubt. Hence aggressive austerity will fail to improve the debt-to-GDP ratio and it will also fail to deliver the surplus the Chancellor so desires.

And this is not to mention the plethora of other problems associated with the fiscal mandate. To name but a few, this policy is:

Short-sighted. Rather than determining whether to invest in long-term infrastructure by conducting a thorough cost-benefit analysis, public investment is determined by whether or not a surplus is being forecast for this year. This means that the government is failing to take advantage of the current low interest rates, which would make public investment more favourable now than it has ever been before.

Compromising public services. Public service spending per person is forecast to fall by 3.7% over this parliament, and by 14.9% between 2010–11 and 2019–20. Given that it is likely that the cuts that were easy to identify and deliver were made first, and there is rising demand for public services due to the growing population, it seems highly improbable that these cuts can be made without severely compromising on the quality of public services.

Inequitable. A huge proportion of cuts is being delivered through the stalling of public sector pay. It seems wildly unfair that public sector workers are having to bear the brunt of austerity, and this is also likely to have ramifications for the ability of the public sector to recruit and retain staff.

The IFS can be quite cautious, and in that context their appraisal of the fiscal mandate is damning and extremely telling. The Chancellor needs to answer for the fiscal mandate and explain:

Why is the government constraining growth in the economy, having real implications for people’s wages and quality of life?

Why are we not taking advantage of historically low interest rates to invest properly in our ageing public infrastructure, securing growth for the future?

Why is the government so apparently unconcerned about the fact that public services are being compromised by harsh cuts?

Written by Florence Bates

Flo graduated in summer 2015 and is currently spending nine months as the graduate intern in the Economic and Social Affairs Department. She works on a range of policy areas across the department, such as researching into employment programs and the …